Yield Farming: How Does It Work?
TLDR;
Decentralized finance (DeFi), a fledgling financial technology that attempts to eliminate intermediaries in financial transactions, has provided the world with numerous new opportunities. One new DeFi yield opportunity is yield farming. It means providing or staking your coins or tokens in exchange for earnings or network fees .
Yield farming is a way of putting your money into work and earning a yield for it. DeFi protocols and smart contracts, which are computer programs, make it possible for you to use decentralized networks to experience this new form of finance.
What is Yield Farming?
Yield farming is a way to generate yield in DeFi that involves locking up cryptocurrency in a decentralized application (dApp) in exchange for token rewards. Yield farmers put their tokens into DeFi apps to trade, lend, or borrow cryptocurrencies. Since these users make the dApps they are interested in more liquid, they are called liquidity providers.
When yield farmers put crypto into DeFi protocols, the crypto is locked into smart contracts that run on their own. A yield farmer will get crypto rewards for their service until they take their money out. This cryptocurrency can come from network fees, interest payments on loans, or rewards for native tokens. Each dApp has its own rules about how long a yield farmer must wait before they can take their money.
Most of the time, yield farming and liquidity mining go hand in hand. The difference is that liquidity mining is about getting unique token rewards that are tied to a protocol.
Most DeFi protocols use "yield farming" as an effective way to encourage people to participate in their applications. In DeFi, the total value locked (TVL) in a dApp can be used to measure the competitiveness of the project. TVL stands for the money that users locked into the protocol in hopes of getting tokens in return. The more money there is to be made with a DeFi project, the higher the TVL.
In some ways, yield farming and staking involves providing tokens for a yield. Yet, there is a great deal of complexity occurring in the background. There are also liquid staking projects that combine yield farming and staking together.
Also Read: What Are Liquid Staking Tokens?
How does Yield Farming Work?
Yield farming is often times tied to the automated market maker (AMM) projects. Liquidity providers (LPs) and liquidity pools are often involved. Let us see how it works.
Funds are deposited into a liquidity pool by liquidity providers. This pool functions as a trading venue where people can buy and sell tokens. These platforms charge a fee, which is then split among liquidity providers based on how much liquidity they provide. This is the basics of how an AMM works.
Also Read: DeFi in the Cosmos Ecosystem
The Calculations Of Return
The expected yield in farming is typically calculated annually. This calculates the expected returns over the period of one year.
Annual Percentage Rate (APR) and Annual Percentage Yield (APY) are two commonly used measurements. The APR does not account for the effect of compounding, whereas the APY does. In this instance, compounding involves immediately reinvesting gains to generate additional returns. However, keep in mind that APR and APY are interchangeable.
It is also important to remember that the APR and APY numbers you see from projects are merely estimates. Even short-term gains are difficult to predict. Why? The market for yield farming is very competitive and fast-paced, and returns can fluctuate rapidly. If a yield farming opportunity generates high APY, more farmers will be attracted by it and start participating, which ends up driving the high return down over time.
Conclusion
Holders of cryptocurrency can let their money sit in a wallet or put it in use in a smart contract and participate in DeFi yield farming. Yield farming is a DeFi native way to generate a yield, which requires you to understand how DeFi works, and how blockchain works. Always remember to DYOR - Do Your Own Research!